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Low ‘neutral’ creating headaches for US Fed

Killian Plastow

— 1 minute read

30 August 2016

Today’s historically low ‘neutral’ interest rates are making it difficult for the US Federal Reserve to guide monetary policy, says Perpetual.

Central bank policy has increasingly been guided by the neutral interest rate, a theoretical rate at which the real economy grows at trend pace while inflation remains stable, Perpetual head of multi-asset investment strategy Matt Sherwood said.

While the neutral rate has typically sat between +1 per cent and +5 per cent when unemployment was at 5 per cent, Mr Sherwood noted that current indicators suggest the present-day neutral rate is lower than this.

This suggests central bank policy is only 40 per cent as effective as it has been in previous business cycles, Mr Sherwood added.

“Indications that the neutral interest rate has fallen notably in the past three years gives the US central bank two dilemmas [concerning] when they should next tighten policy and how fast should they transition the cycle," he said.

“The latter will have implications for other regions, particularly the emerging markets."

Nevertheless, according to Mr Sherwood, the low rates “are to some extent justified for the economic landscape”, but they have given the Fed less room to manoeuvre subsequently.

“Overall, the US Fed is providing less stimuli, has less room for policy error and has less policy delta for the next downturn,” he said.

Mr Sherwood added that recent remarks from US Fed chair Janet Yellen have indicated “no urgency to lift rates” but warned investors not to become complacent about the risk of a raise.

“Any unforeseen hike would weigh on sentiment and spark capital flows out of highly-valued US equities," he said.

"This could create an economic and market dislocation that the Fed cannot fix alone, with expansionary fiscal policy having to be deployed by a gridlocked US Congress and lame-duck US president."